The real estate capital stack represents the multiple layers of financing used to fund a real estate investment. Each layer corresponds to a different risk, return, and repayment priority level. The capital stack typically consists of four main components: Senior Debt, Mezzanine Debt or Preferred Equity, Common Debt, and Common Equity. Understanding these components is crucial for investors, as each plays a distinct role in the financial structure of a real estate deal. Real estate is a unique investment opportunity as leverage is a fundamental tool in financing projects. In a prosperous economic environment, financing projects with debt increases investor returns and ensures the health of a project.
1. Senior Loan
The senior loan is the capital stack's most secure and lowest-risk component. It typically represents 50% to 60% of the total capital structure. In the event of a default, the senior lender has the first lien claim on the property’s assets and income. Because of this security, senior loans offer the lowest return. Banks or Life Insurance companies typically assume this position, and their return is in the form of a set interest rate, either fixed or, more commonly, floating. The risk is mitigated by the lender’s position in the repayment hierarchy, but the return is capped, and there is no participation in the property’s upside.
2. Mezzanine Debt
Mezzanine debt is subordinate to the senior loan. It typically accounts for 10% to 20% of the project's total cost. Mezzanine lenders do not have a direct claim on the property but may secure their investment through an ownership interest in the borrowing entity. This debt carries higher interest rates than senior loans, reflecting its increased risk. In case of default, mezzanine lenders are only repaid after the senior loan has been fully satisfied. The risk is higher than senior debt, as is the expected return.
3. Preferred Equity
Preferred equity is typically an option in lieu of mezzanine debt, and rarely does preferred equity co-exist with mezzanine debt. Preferred equity generally occupies 10% to 25% of the total capital stack. Unlike debt, preferred equity does not have a claim on the property’s collateral. Instead, it receives a preferred return before any distributions are made to common equity or common debt holders (i.e., Promissory Notes). Preferred equity investors take on more risk than senior lenders and, in some instances will be above the mezzanine loan; however, the preferred equity does receive a higher preferred return than most mezzanine loan interest rates and sometimes participates in the residual cash flow of the project (i.e., property's appreciation). The return is higher than mezzanine debt but still does not match the potential upside of common equity.
4. Common Debt (Promissory Notes)
Neutral also provides investors with the option to invest through a promissory note, a form of debt financing. While the risk profile of this instrument is treated similarly to equity, it offers a fixed rate of return and has preferential payment in front of the common equity investors. Promissory notes typically represent a more cost-effective source of capital for a project, as they do not participate in the equity upside of a successful development. However, their fixed return remains unaffected even if the project underperforms, ensuring a consistent payout to investors. Depending on the project, interest is paid quarterly, which gives investors a consistent and predictable cash flow.
5. Common Equity
Common equity sits at the top of the capital stack, representing the most junior and riskiest position. It typically comprises 20% to 35% of the total capital structure. Common equity holders are the last to be paid in the event of liquidation, but they also have the greatest potential for profit. Their returns come from property appreciation, income, and eventual sale proceeds. Unlike common debt or preferred equity, there are no fixed returns other than an accruing 8% to 10% return per annum, and the value of the common equity can fluctuate based on the property's performance. This position offers the potential for significant upside because the investor realizes all the appreciation from taking a site from land to a new building. Additionally, common equity holders receive advantageous tax benefits, which you can read more about in this blog post here.
Comparison of Risks and Returns
- Senior Loan: Lowest risk, lowest return. Secured by the property, first in line for repayment.
- Mezzanine Debt: Moderate risk, higher return than senior debt. Subordinate to senior loans, with both debt and equity-like features.
- Preferred Equity: Higher risk, with higher potential returns. Priority over common equity but no claim on property collateral.
- Common Debt: Higher risk, but fixed return. Third in line for repayment, in the event preferred equity and mezzanine are involved in a project, then common debt is in forth position for repayment.
- Common Equity: Highest risk, highest potential return. Last in line for repayment, fully exposed to property performance.
Common Debt vs. Common Equity
The primary difference between common debt and common equity in the capital stack is the level of risk and potential return. Common Debt provides fixed returns and has priority in repayment, making it safer but with limited upside. Common Equity is more exposed to the property’s performance, offering higher potential returns but at a higher risk. The property's success incentivizes Common Equity investors, as their returns are tied to the profitability of the project. In contrast, common debt investors are focused on the security of their principal and interest payments.
In summary, the real estate capital stack is a balance of risk and return, with each component serving a specific purpose in funding the investment while catering to different types of groups.
